Four Quick Questions...
...with Morningstar’s Todd Lukasik
by Allen Kenney
1Has pricing in the com- mercial property market
stabilized, or do valuations
still have further to fall?
We’ve seen indications that
pricing has stabilized somewhat
recently, but this is based on a
limited number of completed
transactions. Longer term, we
still see a fair bit of uncertainty
surrounding the direction of
commercial property prices, due
to upcoming debt maturities
and macroeconomic factors.
In its February report on
commercial property, the Congressional Oversight Panel concluded that about $700 billion
in commercial real estate loans
that come due between 2010 and
2014 are underwater. We think a
sizable amount of the additional
$700 billion in commercial real
estate loans coming due during
that time frame are loans that
could not get refinanced at existing levels in the current lending
environment. This suggests that
there are at least hundreds of
billions of dollars of incremental
equity capital that need to be injected into commercial real estate
to establish a “proper” leverage
level in the industry. In fact, The
Real Estate Roundtable has estimated this equity gap at about $1
trillion over the longer term.
It’s unclear whether the capital
on the sidelines in combination
with banks’ “pretend-and-extend”
policies will be able to address this
equity gap. Our sense right now
is that the numbers are simply too
large, and, consequently, the prob-
ability of a recovery in asset prices
over the medium term is low.
We expect 2011 and 2012 to be
particularly telling years, however,
as that’s when a lot of the loans
made in 2006 and 2007—years
when property prices and lenders’
risk appetites were simultaneously
peaking—will start to come due.
is still often a disconnect in many
cases between the expectations
of buyers and sellers, resulting in
bid-ask spreads that are too wide
to consummate transactions.
2Will REITs continue to issue equity in 2010?
Provided the economy doesn’t
take a turn for the worse, which
could disrupt capital markets
again, we think the equity and
debt markets will remain open for
REITs in general in 2010. We’d
expect most new equity offerings
to be associated with acquisition
financing, as opposed to equity
offerings simply to pay off debt.
Todd Lukasik, Equity
Research Analyst,
Morningstar Inc.
3The deal-making activity in commercial real estate
still remains relatively restrained. Why?
There are a couple of factors at
play here. Available supply is
being constrained by the government’s support of lenders’ pretend-and-extend tactics. There’s
little incentive for owners of
stressed properties to sell if they’re
not forced to, and banks—with
the government’s consent—seem
willing to extend terms on commercial loans that might otherwise default at maturity, provided
the underlying properties can service the interest payments. These
loan extensions effectively delay
supply hitting the market.
Furthermore, we believe there
4What is one area in which you think REITs have generally done best in managing
through the economic downturn? Where have they fallen
short?
The capital raises of 2009 were
simply astounding. Among the
REIT sectors we follow, leverage ratios (on the basis of net
debt-to-book value of property
assets) improved throughout
2009 by between 215 basis
points and 900 basis points,
with an average improvement of
about 500 basis points.
We think it was REITs’ actions
prior to the downturn that caused
them to fall short when the economy and capital markets headed
south. During the boom years,
REITs in general got overlever-aged and got involved in riskier
business models, including aggressively financed joint ventures,
speculative development pipelines, direct investments in other
real estate companies’ securities,
and so on. These were the things
that caused companies the most
stress during the downturn, and
rightly so. There’s been a recent
focus at many REITs on getting
back to the basics of owning
and managing real estate. While
some progress has been made in
this regard, there is a lot more
work to be done. F
